Posted on October 15, 2013 By iPledg With 0 comments

Crowd Funding – Mitigating Risk

iPledg - Logo - Low-ResolutionTransactions anywhere in the commercial world carry risk. People have to be savvy to the integrity of the vendor or provider at point of sale, as well as considering the ability to provide timely delivery. Then there are issues around warranties, both implied and stated, and the availability of these in case of non performance. Perfection is not the law that governs the commercial world, and this also applies in the realm of equity crowd funding. Law makers in jurisdictions around the globe are now busy considering how to mitigate exposure for a willing yet unprotected public.

It is expected that as we lower the bar to equity fund raising, we lower the sophistication of the issuers (those initiating projects and seeking funding) and investors. It is therefore assumed we are increasing the risk to all parties, and it is these risks that responsible policy makers wish to tone down. There is also a third party that needs to be considered in all of this – the intermediaries, or those who provide the platforms on which issuers make available their prospective offerings.

For intermediaries, there are 3 types of risk. There is possible risk to their reputation should investments go awry. There is also an exposure for regulatory risk, that is should they not follow the laws. And there is legal risk, such as getting caught in the cross fire between an issuer and investor in a case whereby an investor might claim misrepresentation in promotion or lack of due diligence.

The key consideration for regulators is in dealing with the risk to investors. Equity crowd funding opens up the world of investing to retail investors, exposing them to the possible misuse of funds raised, or the misappropriation of their investment by intermediaries. Given that in most cases such retail investment is for relatively small amounts, this low loss may cause them to just “write it off” rather than requesting their loss be investigated further, thus opening up a greater opportunity for fraud or even money laundering. Investors may not understand the risk associated with investing, leaving the unsophisticated investor further exposed. One must also consider the calibre of some issuers who may turn to equity when they can’t get funding through traditional means, meaning that with even the most honourable of intent, their proposition is by nature that of a greater threat. Startups by definition are already high risk, so this end would be the highest risk end of an already high risk group.

The complexity is further compounded when one considers the issue of valuation. The initial value of one’s equity may be intangible. The demands for transparency in such offerings are far less than public companies, so the way in which the value of shareholding is determined is not only difficult in the outset, but the ongoing rise and fall in share value may be hard to determine, let alone monitor. Equity in such investments would be “illiquid” with no secondary market on which to sell them. Given that the value of the investment would be hard to draw on or recover, and the difficulty in being able to value it, such shareholding would not be able to be used as collateral for future borrowings. And given there is not the same level of due diligence and no prospectus, investors may not have the same right of recourse.

Before the internet, the issue was less of a concern, due to the area of any fallout being relatively well contained. Traditionally it was a rather small audience to which such an offering could be made. Now with the internet the reach and risk are increased, and the casual nature of the internet brings with it a generally lower level of scrutiny.

However, despite all of this, we have regulators around the world establishing frameworks so that economies can benefit from this much needed form of commerce. Whilst equity crowd funding is new by way of legislation in many parts of the world, organisations such as the Australian Small Scale Offerings Board (ASSOB) have almost 8 years of equity crowd funding experience since they drove the need to change a class order allowing for the raising of up to $2mil from upto 20 non-sophisticated investors over any 12 month period. Under the watch of the current regulators such as ASIC, the Department of Fair Trading, and ACCC, ASSOB has built a bank of experience on which governments can now draw to implement more broad based equity crowd funding legislation. Equity crowd funding is not “new to world”, so the regulation and framework governing project creators (issuers), project supporters (investors), and operators of platforms (intermediaries) should be an extension of current law adapted to better suit a broader set of retail investors.

In addition to the “law” is the underlying “spirit” of crowd funding, namely by virtue of the “Third Tier” concept. Investors derive comfort from not being the first to dive in, with this reassurance being provided by the first tier – the first follower, the family, friends and those closest to the issuer. The second tier – friends of friends – then buy in and bolster the momentum. The third tier then take note, typically when the campaign hits 30% funding, and that’s when the smart money kicks in, based on logical reasons to support and invest.

In a wonderful time of economic renaissance when the democratisation of funding is spreading throughout the world, equity crowd funding is finally being looked at by governments who want to protect to retail investor. Ironically, in most parts of the world, you can drop $1,000 into a poker machine without anyone protecting you, but you cannot invest $1,000 into a local startup with the chance of providing jobs, supporting the local economy at grass roots level, and with the chance of reaping an ongoing return. Thankfully sensibility is starting to prevail as governments and economies around the world begin to seriously and responsibly consider equity crowd funding as an integral part of their commercial landscape.

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